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Here's an explanation I wrote for our weekly newspaper feature:

The Fool School

The Price-to-Sales Ratio

Investors frequently evaluate companies based on earnings. But what if there are no earnings, such as with young upstart companies or firms in temporarily tough times? You can focus on revenues instead, with the price-to-sales ratio (PSR).

The PSR takes the market capitalization of a company and divides it by the last 12 months' revenues. The market cap is the current value that the market is giving the company, arrived at by multiplying the current share price by the number of shares outstanding.

Imagine Iditarod Express (ticker: MUSH), famous for its slogan, "when it absolutely has to get to a remote corner of Alaska in the next few weeks." If MUSH has ten million shares outstanding, priced at $10 a share, then its market capitalization is $100 million. If it had $200 million in sales over the last four quarters, its PSR would be 0.50 ($100 million divided by $200 million equals 0.50). Compare the PSR with sales growth. A high PSR isn't necessarily bad if sales are growing rapidly.

The price-to-sales ratio is especially handy with start-ups, small-cap companies, and unprofitable firms. Assume that Iditarod Express lost money in the past year, but has a PSR of 0.50 when its peers have PSRs of 2.0 or higher. If it can turn itself around and start making money again, it's likely to have a substantial upside if it can match competitors' profit margins. There are some years during recessions when none of the auto companies are profitable. This doesn't mean they're all worthless and there's no way to compare them. You just need to use the PSR instead of the price-to-earnings (P/E) ratio. Measure how much you are paying for a dollar of sales instead of a dollar of earnings.

Despite its usefulness, the PSR should never be the only number you crunch. It can give you a nice context for a company's value relative to its industry peers but while sales growth is great, revenues must be transformed into rising earnings to make shareholders happy. How much a company earns off its sales will eventually drive up the value of the business and the stock.
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